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Normandin Beaudry

The difficult financial position of pension plans

LinkedIn

There, in black and white

NB Bulletin Vol. 5 N. 8, July 2002

It is no longer a secret to anyone that the last quarters have been particularly difficult on pension fund investment returns. While the outlook for 2002 was slightly more positive due to the better performance of the first few months of the year¸ financial scandals at Enron¸ Tyco¸ WorldCom and Xerox¸ have negatively impacted various stock markets worldwide. Therefore¸ the value of the S&P 500 index has practically returned to the same level of the bottom plateau reached on September 21¸ 2001.

Returns for the main market indexes (since 2000) are shown in the following table:


 

Asset CategoryBenchmark Index20002001On June 30 2002

Short-term Securities 91-day Treasury Bills 5.5% 4.7% 1.0%
Canadian Bonds SCM - Universe Index 10.2% 8.1% 2.0%
Canadian Equities S&P/TSX Composite Index(1) 19.0% -8.4% -6.3%
U.S. Equities S&P 500 Index (in CAN $) -5.5% -6.5% -17.2%
International Equities EAFE Index (in CAN $) -10.6% -16.4% -6.0%
Balanced pension fund(2)   8.0% -1.9% -3.9%

(1) The TSE 300 Capped Index before March 22¸ 2002.

(2) Average funds with a reference portfolio consisting of: 5% in Short-Term Securities¸ 40% in Canadian Bonds¸ 30% in Canadian Equities¸ 12.5% in U.S. Equities and 12.5% in International Equities.

General Comments

The year 2002 is lining up to be a second difficult year for pension funds. More specifically¸ the U.S. and international markets are experiencing a third difficult year in a row.

In the last ten quarters¸ the combined return of various market indexes for a balanced pension fund was 0.7% on an annual basis¸ which is significantly lower than the return anticipated in actuarial valuations. Moreover¸ the actuarial value of assets (spreading gains and losses over a period of several years¸ and used for the funding valuation) can be higher than the market value of the assets (which is used for the solvency evaluation). Depending on the date of the next actuarial valuation (required at least every three years)¸ the financial position of certain pension plans could result in deceiving surprises for some employers and pension committees.

In pension funds where the liabilities of retired members constitute a significant part of the actuarial liabilities¸ a strategy of matching the liabilities with assets for this group of members minimizes fluctuation risks regarding the financial position. Pension funds that have implemented this practice over the last few years generally have managed to limit damages¸ without eliminating them completely.

Questions Regarding Current Assumptions and Investment Policies

Given the level of risk premium associated with equities and the current level of expected bond performance¸ it may be time to re-evaluate long-term return assumptions used for funding actuarial valuations (as well as other related assumptions¸ such as the inflation rate). Although assumptions regarding funding must reflect the financial position expected in the long term¸ recent developments in the financial markets are forcing pension committees and their actuaries to review the assumptions to be used in the short term and the current investment policy.

Accounting Expense

Finally¸ we must consider the accounting expense¸ which is significant for some organizations¸ especially if experience gains are presently being amortized. Depending on the method chosen for the use of the "10% corridor"¸ the accounting expense could increase significantly because of the amortization of gains that are lower than in the past¸ or even the amortization of losses¸ on top of lower than expected investment returns caused by low interest rates. The status of income and expenses could also be significantly affected. Even if the organization sponsoring the plan is not subject to these accounting rules¸ pension funds may have invested in stocks that need to comply with these accounting rules.

 

Please feel free to contact us for additional information.

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